Chapter 5

Elasticity and Applications Price Elasticity of Demand and Its

Determinants

 Availability of Close Substitutes

Elasticity
 Necessities versus Luxuries
 Allows us to analyze supply and  Definition of the Market
demand with greater precision.  Time Horizon
 Is a measure of how much buyers and
Demand tends to be more elastic:
sellers respond to changes in market
conditions.  the larger the number of close
substitutes.
The Elasticity of Demand
 if the good is a luxury.
Price Elasticity (Own Price)  the more narrowly defined the
market.
 A measure of how much the quantity
 the longer the time period.
demanded of a good responds to a
change in the price of that good. Types of Elastic Demand
 When we talk about elasticity, that
Price Elastic = ED > 1
responsiveness is always measured in
percentage terms. -QD changes substantially or more
 Specifically, the price elasticity of proportionately to a change in price.
demand is the percentage change in
quantity demanded due to a Price Inelastic = ED < 1
percentage change in the price. -QD changes slightly or less
-The price elasticity of demand is computed as proportionately to a change in price.
the percentage change in the quantity Unit Elastic = ED = 1
demanded divided by the percentage change in
price. -QD changes by the same percentage or
proportionately to a change in price.
Percentage change in quantity demanded
Price elasticity of demand =
Percentage change in price
Variety of Demand Curves
*NOTE* Inelastic Demand
The Midpoint Method
 Quantity demanded does not respond
 The midpoint formula is preferable strongly to price changes.
when calculating the price elasticity of Elastic Demand
demand because it gives the same
answer regardless of the direction of  Quantity demanded responds strongly
the price change. to changes in price.
(Q2  Q1 ) /[(Q2  Q1 ) / 2] Perfectly Inelastic
Price elasticity of demand =
( P2  P1 ) /[( P2  P1 ) / 2]
 Quantity demanded does not respond
to price changes.
Perfectly Elastic

 Quantity demanded changes infinitely

with any change in price.

Unit Elastic

 Quantity demanded changes by the

same percentage as the price.

-Because the price elasticity of demand

measures how much quantity demanded
responds to the price, it is closely related to the
slope of the demand curve.

-But it is not the same thing as the slope!

Total Revenue and the Price Elasticity of

Demand

Total revenue
 Is the amount paid by buyers and
received by sellers of a good.
 Computed as the price of the good
times the quantity sold.

TR  P  Q
*NOTE*

Total Revenue = Total Expenditures

Relationship Between Price and Total Revenue

1. Demand is Inelastic
 Increase in price causes the
quantity demanded to
decrease less than
proportionately therefore an
increase in total revenue.
 Decrease in price causes the
quantity demanded to increase
less than proportionately
 therefore a decrease in total
revenue
2. Demand Elastic
 Increase in price causes the
quantity demanded to
decrease more than
proportionately therefore a
decrease in total revenue.
 Decrease in price causes the
quantity demanded to increase
more than proportionately
therefore an increase in total
revenue.
3. Unit Elastic
 Increase in price causes the
quantity demanded to
decrease by the percentage
proportionately therefore total
revenue remains the same.
 Decrease in price causes the
quantity demanded to increase
by the percentage
proportionately therefore total
revenue remains the same.
Income Elasticity of Demand
 Measures how much the quantity
demanded of a good responds to a
change in consumers’ income.
 It is computed as the percentage
change in the quantity demanded
divided by the percentage change in
income.
Percentage change
in quantity demanded
Income elasticity of demand =
Percentage change
in income
Types of Goods
Normal Goods - One whose demand increases
as people's incomes or the economy rise.
Inferior Goods - A type of good for which
demand declines as the level of income or real
GDP in the economy increases.
 Higher income raises the quantity
demanded for normal goods but
lowers the quantity demanded for
inferior goods.
Goods consumers regard as necessities
tend to be income inelastic
Examples include food, fuel, clothing,
utilities, and medical services.
Goods consumers regard as luxuries tend to
be income elastic.
Examples include sports cars, furs, and
expensive foods.
*NOTE*
 Income Elastic – Purchase of income
spent on normal good rises as income
increases
 Income Inelastic – Purchase of income
spent on good decreases as income
rises.
Cross-price elasticity of demand
 A measure of how much the quantity
demanded of one good responds to a
change in the price of another good,
computed as the percentage change in
quantity demanded of the first good
divided by the percentage change in the
price of the second good.
%change in quantity demanded of good 1
Cross - price elasticity of demand 
%change in price of good 2
Substitute Goods – Positive or ECP > 0
Complementary Goods – Negative or ECP < 0
Price Elasticity of Supply
 Measure of how much the quantity
supplied of a good responds to a change
in the price of that good.
 Price elasticity of supply is the
percentage change in quantity supplied
resulting from a percentage change in
price.
 Depends on the flexibility of sellers to
change the amount of good to produce.

 The price elasticity of supply is

computed as the percentage change in
the quantity supplied divided by the
percentage change in price.

Percentage change
in quantity supplied
Price elasticity of supply =
Percentage change in price

The Price Elasticity of Supply and Its

Determinants

 Ability of sellers to change the amount

of the good they produce.

Beach-front land is inelastic.

Books, cars, or manufactured

goods are elastic.
  Time period

Supply is more elastic in the

long run.

SUMMARY

• Price elasticity of demand measures

how much the quantity demanded
responds to changes in the price.

• Price elasticity of demand is calculated

as the percentage change in quantity
demanded divided by the percentage
change in price.

– If a demand curve is elastic,

total revenue falls when the
price rises.

– If it is inelastic, total revenue

rises as the price rises.

• The income elasticity of demand

measures how much the quantity
demanded responds to changes in
consumers’ income.

• The cross-price elasticity of demand

measures how much the quantity
demanded of one good responds to the
price of another good.

• The price elasticity of supply measures

how much the quantity supplied
responds to changes in the price.

• In most markets, supply is more elastic

in the long run than in the short run.

• The price elasticity of supply is

calculated as the percentage change in
quantity supplied divided by the
percentage change in price.

• The tools of supply and demand can be

applied in many different types of
markets.